Monday, April 30, 2012

The ECB had been a big disappointment for the periphery governments. These nations have been asking the central bank to help support their government bond prices by continuing and expanding the Securities Markets Program (SMP) to directly purchase their government debt. But the ECB, particularly the German contingent, wanted none of that. And so the program was stopped.

Reuters: The European Central Bank
kept its bond purchase programme dormant for the seventh week in
a row this week, despite increasing unease in financial markets
about the situation in Spain.

However back in March some financial engineering took place that would make even an experienced Wall Street structurer jealous. The goal was to achieve a "backdoor SMP" in spite of the ECB's policy to put the SMP on hold. Let's take Italy as an example. Here are the steps used to achieve this financing:

1. Banks would issue bonds and retain them (a bank would effectively lend to itself).
2. The government would slap a guarantee on those bonds (after all it doesn't directly cost the government anything for this guarantee).
3. The banks would then post their own bonds with the ECB, who accepted them as collateral because of the government guarantee. Using these bonds as collateral the banks would borrow under the LTRO program.
4. With this new LTRO cash the banks would buy Italian government paper, which they also posted as collateral to borrow more or would hold the paper in reserve to meet margin calls.

Barclays Capital: - Data show that €105bn of governments securities (29%) have been used in the ECB
collateral pool as of the end of March, with €98bn still available for additional funding. We
note that, as of August 2011, only €18bn were used in the ECB collateral pool (with €57bn
available for additional collateral).

The end result was that the Italian government ended up with the LTRO cash and the ECB got stuck with government risk on its balance sheet for 3 years. To put it another way, the ECB was not lending to the government directly. Instead it was lending to a government guaranteed entity (the bank), who in turn was lending to the government.

Backdoor SMP

Hard to believe, right? Here is the data. Below is the breakdown of the collateral posted by all Italian banks with the ECB in August 2011.

Italian banks' collateral composition (Source: Barclays Capital)

And here is the collateral held by these banks with the ECB last month. Note that the scale on the two charts is completely different as banks' balance sheets have ballooned during this period. And here we have the €76bn of government guaranteed bonds posted as collateral. In addition there is €25bn of unsecured bonds that are not guaranteed but somehow "qualified" as collateral (discussed here back in January). Italian banks also posted a great deal more corporate loans and corporate bonds they held on their balance sheet.

Barclays Capital: - Most of the government guaranteed bonds have been issued and retained by banks for the
sole purpose of creating collateral to access the ECB. According to Borsa Italiana (Italian
Stock exchange) data, 14 Italian banks issued a total of €40.4bn of government guaranteed
banks bonds on the day before the first 3y operation in December, and in total, at the end of March, the issuance amounted to €87bn (with a collateral value of €77bn net of haircuts),
with many small and medium sized banks issuing bonds of a small size (note that the
amount issued by the five main banking groups amount to €49bn). Most of the bonds
issued for the first 3y LTRO were with short maturities and were subsequently replaced by
longer maturity bonds (issuance in 2012 has been under the new, cheaper, guarantee
scheme, which entered into force on 1 January 2012). At the end of March, the Government
guaranteed bank bonds represented around 21% of the total collateral pool pledged by
Italian banks.

And of course this resulted in a massive purchase of Italian government debt using new LTRO funds (as discussed earlier). The periphery governments got what they wanted - the ECB indirectly financed their bonds. The issue of course is that this still turned out to be not nearly enough to stabilize periphery yields over the longer term.

The dynamics of different parts of the term-structure often look quite different. Examine this graph, for instance (the x-axis is in Excel format dates, so from 4-Jan-2005 through 18-Dec-2009):

click to enlarge

This graph superimposing 1d, 1w, and 3m rates shows that they are tightly grouped at the same level at any given time in the graphed period. All of the rates are clearly strongly influenced by administered Fed rates, indicated by the early flat section. The 3m rate is the smoothest, so the others can be regarded as occasionally straying from the 3m base before quickly being brought to heel. The daily volatilities of the 1d and 1w rates, however measured, are not a good guide to longer-term volatilities. The 3m rate has undergone a regime change that induces a drift which is quite significant compared to daily volatility, and would have to be taken into account if measuring 3m daily volatility.

(I note in passing that the 1d and 2w excursions are not very random-looking, they have a fair amount of structure; there is an initial regime were small deviations are equally likely to be either higher or lower than the 3m rate, followed by a regime switch to a period when there appear to be large excursions exclusively to the upside, followed by another period of more symmetric deviations, followed finally by a fourth period in which all deviations are to the downside. The structural breaks or regime changes that I am claiming can be seen here can be very violent for some currencies, and pose significant problems in risk modeling.)

Looking at the graph, the target of mean reversion for 1d and 1w rates ought to be the current 3m rate, so that the 3m rate could be regarded as the driving process for this part of the curve. But the typical IR model does not support this feature: a given rate usually reverts to either a historical or an implied rate of the same constant-maturity tenor or of a given fixed maturity.

Sunday, April 29, 2012

CNBC: - Carrefour, Europe's biggest retailer, said it would focus on cutting prices to lure back consumers as it braced for another tough year as cash-strapped shoppers reduced spending.

The French group, posting a 0.1 percent drop in underlying first-quarter sales, said it was hit by continued weakness in its core French hypermarkets and in austerity-hit Southern Europe, where shoppers cut back on purchases of discretionary non-food items.

This problem is not unique to Carrefour. The Eurozone is experiencing a sharp contraction in the retail sector.

BBC: - Retail sales in the three largest eurozone economies - Germany, France and Italy - have fallen to their second lowest level on record, a survey says.

The purchasing managers' index (PMI) for the three countries, compiled by research firm Markit, fell to 41.3 in April, down from 49.1 in March and the weakest reading since November 2008.

A reading below 50 indicates shrinking activity.

The chart below shows the Retail Purchasing Managers Index (Retail PMI) for the Eurozone, a leading indicator for the official retail sales numbers.

Eurozone Retail PMI (source: Markit Partners)

Here is a quote from Trevor Balchin, the author of the Eurozone Retail PMI:

Trevor Balchin (Markit Partners): - “The latest batch of retail PMI data for the Eurozone portrayed a worryingly steep downturn on the high street. Coming on the back of disappointing flash estimates for the manufacturing and service sectors, the retail data point to a deepening recession at the start of the second quarter. The April Retail PMI signalled the fastest fall in sales since the record contraction seen in late-2008."

This decline however is not limited to the Erozone periphery. In fact the French Retail PMI is now below the 2008/09 levels - at record lows. Some of this can be attributed to the uncertainty around the French elections. Nevertheless this squeeze on the French retailers is bound to pressure the French GDP.

French Retail PMI (source: Markit Partners)

Jack Kennedy, author of the France Retail PMI, had this to say:

Jack Kennedy (Markit Partners): -
“The latest PMI figures point to a dismal month for French retailers in April. Although survey respondents indicated that weakness was partly attributable to uncertainty surrounding the presidential elections, the fragile economy is also clearly a large factor weighing on consumer spending. Retailers will be hoping for something of a rebound once the elections are over, but the sector still looks likely to be a drag on second quarter GDP.”

Mario Draghi's "signs of stabilization" statement is coming back to haunt the central bank. Another rate cut from the ECB, though largely symbolic in nature, is coming shortly.

Once in a while an article on commercial real estate appears that seems to point to improvements in the commercial real estate (CRE) credit conditions.

CoStar Group: - While a host of banks are still working through mounds of distressed commercial real estate assets, a number have decided the time is right to jump back in. Those banks that are lending again see lower risk owner-occupied properties and multifamily properties as preferred targets. But with lenders focusing on the same 'safe shelter' property sectors, it is creating widespread competition for the better-quality borrowers in those areas.

Is there really a thaw in US CRE credit or are banks simply rotating into a higher quality portfolio? The answer can be seen in the latest data from the Fed. It points to an ongoing and almost a linear decline in the overall CRE lending by large US banks.

Commercial real estate loans as percentage of large US banks' total bank credit
(weekly data, source: the Fed)

With CMBS maturity wall still looming, and a shaky macroeconomic backdrop, large US commercial banks are in no hurry to get back into CRE lending. Sure there are some interesting opportunities for banks, particularly in the multifamily sector that has been doing well. But as a whole, banks are rotating out of the sector at an almost constant rate since 2009.

In his latest article on the Eurozone, Ambrose Evans-Pritchard points to the collapse of demand for credit in the Eurozone (hat tip Greg Merrill).

The Telegraph: - The long-feared credit crunch has mutated instead into a collapse in DEMAND for loans. Households and firms are comatose, or scared stiff, in a string of countries.

Demand for housing loans fell 70pc in Portugal, 44pc in Italy, and 42pc in the Netherlands in the first quarter of 2012. Enterprise loans fell 38pc in Italy. The survey took place in late March and early April, and therefore includes the second of Mario Draghi’s €1 trillion liquidity infusion (LTRO).

This blanket assessment however is not entirely correct. In certain Eurozone nations demand for credit, particularly from small and medium size enterprises still exists. This demand is not always about expansion. Many of these businesses rely on credit to finance inventories, meet payroll, etc. The problem is often the declining availability of credit.

Let's take a look at Portugal for example. Here are the results from Banco de Portugal (Portugal's central bank) survey of the nation's credit conditions. The assessments of credit for enterprises clearly point to rising demand and dwindling supply (dashes indicate the expectations of credit institutions).

Source: Banco de Portugal

Source: Banco de Portugal

Mr. Evans-Pritchard rightfully points out that demand for credit from households has declined dramatically in the past couple of years. But that is not new. The largest credit demand declines from households in Portugal took place in late 2010 to early 2011. In fact demand for mortgages is expected to reverse the declines (though ever so slightly) in 2012 Q2 as household formation takes its course. The problem is that the supply of credit for mortgages is expected to decline just when the demand begins to stabilize.

Source: Banco de Portugal

A survey from the ECB (hat tip Kostas Kalevras) also points to an increasing demand for credit that corresponds to dwindling supply. Below are the responses of small and medium-sized enterprises in Portugal that identified "access to finance as the most pressing problem" (percentage of respondents).

"Access to finance as the most pressing problem" (percentage of respondents; source: the ECB)

It is likely that many households and businesses, keenly aware of the lack of available credit, are simply not seeking new funding now, which translates into what looks like declining demand. But at least when it comes to credit conditions in Portugal, the problem is the lack of supply, not the demand.

Saturday, April 28, 2012

Risk measurement models often attempt to project the behavior of the yield curve based on historical rate movements. But the assumptions that go into such modeling could often produce misleading results. Here is why.

The chart below shows the recent historical volatility of yields along the US treasury curve. These are the standard deviations of weekly rate changes in basis points over the past 16 months (from 1/1/11 to today). The historical volatility curve shown here makes sense intuitively, with longer term yields being absolutely more volatile than the short term yields.

Absolute weekly historical volatility of rates from 1/1/11 to 4/27/12 in basis points

But that's not the whole story. An alternative way of looking at rate volatility is on a relative basis. That would be the change in each rate as a proportion of the rate at the time. For example if the 10-year rate is 2% and it moves by 10 basis points, the relative move would be 5% (10bp/200bp). This model tells us that if the 10-year rate becomes 4%, the equivalent move would be 20bp (5% of 4%). As rates rise, so do the expected moves in basis points. The shape of the relative historical volatility is shown below and has the opposite slope of the absolute volatility. This is also fairly intuitive because even small rate moves at the short end produce large relative moves with rates being close to zero.

Relative weekly historical volatility of rates from 1/1/11 to 4/27/12

(% of rate)

Which one is the correct approach to model movements in interest rates? Rate movements are not like stocks for example that can almost always be modeled using relative moves (lognormal distribution). But using absolute movements is not always correct either because a 10bp move in the 2-year rate in 2006 was routine but would be considered a huge and far less likely move now when short-term rates are near zero. The reality is somewhere in-between.

Also the shape of the rate volatility curve has not always been the same. The charts below show the same results for the 2006-2007 period (unfortunately the 1-year and the 7-year data was not available for that period). Not only is the absolute and the relative volatility far smaller than the current levels, but the volatility curves are both relatively flat (in part due to the flat or inverted yield curve during that period).

Absolute weekly historical volatility of rates from 1/1/06 to 4/27/07 in basis points

Relative weekly historical volatility of rates from 1/1/06 to 4/27/07

(% of rate)

So the next time your risk manager shows you a VAR number of a rate product portfolio, ask her which volatility and term structure assumptions as well as the historical periods were used. The answer could make all the difference.

Friday, April 27, 2012

It’s Friday - a good day for a somewhat different type of post. Several readers have recently asked for a “cheat sheet” on the French political landscape. The US mass media has done a poor job in covering the French elections. Describing French politicians to a US audience is difficult due to the tremendous differences in the electoral process, the issues, the political parties, and the candidates. For example the Socialist Party is a major (“mainstream”) force in France, while it is more of a “fringe” movement in the US. Therefore one way to provide a quick (although very simplistic) picture of the current French candidates is to “map” each candidate into a US politician that is in a similar spot on the political spectrum. Clearly there are multiple ways to approach this and each could be debated for hours, but here is the first shot at it. Those who want more details on each of the politicians, including full backgrounds, etc., should consult Wikipedia.

To begin with, the chart below shows the first round election results of the current French candidates for presidency. This gives an indication (voter turnout varies materially for different parties) of the popular support that each politician has in France.

The results of the first round of elections in France

And here is the map. Strangely but purely coincidentally some of the countrparts look alike or would make great couples. If anything they should get to know each other because they surely have quite a bit more in common than they thought.

On a more serious note, according to BNP Paribas, the outcome of the election will impact the French inflation rate:

BNP Paribas: Inflation and purchasing power is an important theme of the French election campaign, although not as important as it was in 2007. Still, whoever wins, a number of planned economic measures will affect the inflation outlook.

President Nicolas Sarkozy has already got parliamentary approval for a VAT hike, but if he loses the election, it will be cancelled. Inflation may be less volatile short term if François Hollande wins; he is planning a temporary cap on petrol prices at the pump this summer.

Labour costs are the main issue that could impact inflation and the competitiveness of the French economy in the longer term. The outlook will vary considerably, depending on who wins the election.

Investors in inflation-linked products cannot ignore the impact of the French election, though the lack of detail in the Socialist platform makes it impossible to come up with a reliable estimate of the impact on inflation of a Socialist victory.

The ISI Group has been doing some great research on China's economy - the work is often better than what comes out of the large dealer research departments. Last night we saw the latest result from the MNI business survey.

MNI (attached): -­ Overall Chinese business conditions showed a slight improvement in April as new
orders rose but a price squeeze and renewed credit tightening left a decidedly mixed result for the MNI
China Business Sentiment Indicator.

The overall current business conditions index rose after falling last month, hitting 56.04 in April after
54.81 in March and 58.87 in February. It was at 69.20 a year ago. The result was up from 55.40 in the flash
survey a week ago.

ISI however looked beyond the headline numbers to make a seasonal adjustment, properly incorporating the Lunar New Year holidays. The seasonally adjusted MNI number is 49.7, down for a third consecutive month. China's economy is slowing down.

MNI: The biggest surprise in the survey was the result for the index of current input prices, which rose to
84.48 in April, the highest result in the survey's more than six-­year history, from 72.28. That result indicates
that a majority of the companies surveyed were paying higher prices, a trend backed up by comments from
some of the companies themselves.

"The cost of cotton has risen a lot and the whole industry is suffering," said an official at a textile
company. "It's not easy to make even little profit."
Other industries are also seeing higher prices.

"Our prices received are falling while raw material costs are rising," said an official at a machinery
maker.

Indeed, the April result saw a sharply divergent trend for prices, with the prices received index dipping
back under the 50 level which separates growth or expansion from contraction. The index was at 46.71 in
April from 50.00 in March and 54.11 in February.

"The whole industry is facing the serious problem of over capacity, and we have had to lower our prices,"
said an official at a chemical company. "We don't have an optimistic outlook for the future;; things could get
worse."

The latest Spanish unemployment rate was published today. There isn't much one can say about it other than to draw the following parallel.

Here is the chart of US unemployment rate going into the Great Depression: it maxed out at 21% - 22% (early to mid 30s).

US unemployment rate (source: Wikipedia)

This is Spain's unemployment rate now: 24.4%.

Spain's unemployment rate (source: INE)

Even with last night's downgrade of Spanish government debt to BBB+, given these unemployment figures it is hard to see how these bonds could still be classified "investment grade".

Update:

A quote from Ambrose Evans-Pritchard (via e-mail): - ... you may be interested to know that Spain's unemployment would be about 4p to 5pc higher under the 1990s method of counting. There was a Bank of Spain study on this.

Thursday, April 26, 2012

Today we saw stronger than expected pending home sales in March from the National Association of Realtors.

Bloomberg: The index of pending home purchases rose 4.1 percent to 101.4, the highest level since April 2010, after a 0.4 percent gain in February that was revised from a previously estimated 0.5 percent drop, the National Association of Realtors reported today in Washington. The median forecast of 43 economists surveyed by Bloomberg News called for a 1 percent rise in the measure, which tracks contracts on previously owned homes.

This is great news for the housing market, but there is a problem. Typically the pending home sales index leads existing home sales by a month or two. But recently the actual closings have not kept up with this index and the gap has gotten wider. Here are the two indices from 2002.

And here are the same two indices over the past year.

It shows that many pending transactions never make it to closing. The only explanation for this is the persistence of tight credit conditions in the housing market, with buyers unable to obtain adequate financing in order to close. This is in spite of record low mortgage rates.

Within a month or two we should know if there have been improvements in the rate of closings. If so, we should see existing home sales pick up sharply. But given the recent history of the two indicators, this improvement is far from certain.

WSJ: - China, Japan and South Korea, Asia's largest oil consumers, significantly cut imports of Iranian crude in the first quarter of 2012 after the U.S. and the European Union moved to tighten sanctions against Iran over its nuclear program, opening the way to rival suppliers.

Iran is the world's fifth-largest oil producer, exporting about 2.26 million barrels a day of crude in the first half of 2011, according to the U.S. Energy Information Agency.

China, Japan, India and South Korea made up the bulk of its customers, accounting for 59% of its exports or 1.46 million barrels a day. Iran, on the other hand, accounts for about 10% of each of those countries' crude imports.

Between January and March 2012, China cut Iranian crude purchases by a third to about 350,000 barrels a day because of a pricing dispute which has since been resolved--it has consistently said that it respects only U.N.-imposed sanctions.

Japan and South Korea cut imports by more than 20% to 330,000 barrels a day and 200,000 barrels a day, respectively, as political pressure from the U.S. mounted.

Japan cut imports from Iran in 2011 and said it would accelerate cuts this year. South Korea has moved more slowly, saying it will review planned cuts with the U.S, and it is in talks with Washington over how much it will need to trim to avoid retaliation

To compensate for the Iran cuts, OPEC (ex-Iran) and in particular Saudi Arabia is pumping at recent record levels.

Source: Barclays Capital

In addition to the hole left by the Iran sanctions, the Saudis are pressured to pump more in order to meet their own rising domestic demand. This is putting strains on OPEC's spare capacity. Even though the Saudis are reporting some 1.8 mb/d of capacity, according to Barclays Capital, the sustainable component of this is closer to 1 mb/d.

OPEC spare capacity (Source: Barclays Capital)

Aware of the capacity constraints and concerned about not being able to meet demand, the Saudis are rapidly increasing oil in storage.

The Saudis are preparing for prolonged Iran sanctions, rising domestic demand (the Saudis are part of the BICS demand growth with close to 7% GDP growth), and possible supply disruptions should tensions with Iran escalate. Above all, this tells us that OPEC's limited spare capacity is becoming a concern.

Wednesday, April 25, 2012

As predicted earlier this year, Japan continues to struggle with its energy needs. The chart below shows the recent trend in Japan's imports of residual fuel oil. Residual fuel is used for electricity generation, industrial process and space heating, as well as fuel for large ships. Japan had always bought some fuel oil for shipping and certain industrial processes, but nuclear generators had in the past been the dominant source of electricity. Now the source of power has been replaced by expensive fuel oil.

Source: Joint Organisations Data Initiative

These fuel imports are quickly translating into a rising trade deficit.

The Finance Ministry’s preliminary trade data showed a 4.41 trillion yen ($54 billion) trade deficit for the fiscal year that ended March 31.

The chart below shows Japan Merchandise Trade Balance (seasonally adjusted) from the Ministry of Finance. This is not the full trade deficit, but is a strong indicator of trade flows.

Monthly index, SA. Source: Bloomberg/Ministry of Finance

AP/WP: - All but one of Japan’s 54 nuclear power reactors are offline in the aftermath of a nuclear crisis set off in March 2011 by the tsunami in northeastern Japan. That has forced Japan to rely on oil and gas-fired generation to supply electricity.

Although the central government, eager to restart some of the reactors, has been carrying out safety tests on the nuclear plants, local officials have been wary of giving a go-ahead.

The earthquake and tsunami also hurt manufacturing, not only in northeastern Japan but for those companies that had counted on supplies from that area. Exports for the fiscal year dropped 3.7 percent from the previous year, while imports climbed 11.6 percent, according to the Finance Ministry.
....
The ministry said comparable trade data go back to fiscal 1979, but the latest deficit number was also bigger than those dating back to the Meiji period, starting in 1868.

Japanese companies have also been gradually moving production overseas to curb damage from the strong yen, which erodes the value of export earnings.

Analysts say that if expensive fuel imports continue, Japanese consumers will likely foot higher utility bills, and that could dampen consumer spending, further hurting the economy.

Update from Barclays Capital:

... preliminary data for March show total oil input for electricity generation in Japan
averaged 527 thousand b/d, some 300 thousand b/d (150%) higher than a year earlier. Just
one nuclear power plant was operating in Japan last month, and from early May, nuclear
output will literally be zero. While Japan’s prime minister and other cabinet ministers are
currently attempting to persuade local residents of the need to restart nuclear facilities,
Argus analysis of the stances of local politicians suggests that as much as 35.2 GW of
Japan’s 49.1 GW nuclear fleet could be blocked from restarting indefinitely.

Credit Suisse recently pointed out that the latest decline in global issuance of corporate bonds likely drove decreases in bond trading volumes. This has been observed in certain equity markets as increased IPO activity boosts overall volumes. The dynamics in credit seem to be oriented around inventories. With the overall declines in dealer inventories, trading desks concentrate their activities around new issue bonds. Even under the Volcker rule, temporary positions to facilitate new issue will be permitted. Secondary markets positions however are expected to be curtailed. And limited inventories translate into less trading and less liquidity. As the charts below show, daily trading volumes in the HY market declined with the drop in HY issuance.

Source: CS

This relationship between new issuance of bonds and bond trading volumes wasn't as pronounced last year. Fear driven liquidations by portfolio managers may have kept the volumes up even with little new issue in August and September. But as secondary market inventories tighten, the expectation going forward is that trading volumes will increasingly depend on the sizes and volumes of newly issued bonds.

Based on recent history, the investment grade (IG) CDX is still outperforming high yield (HY) CDX. That is on a relative basis IG spread is tighter - now back below 100bp.

IG vs HY CDX

Portfolio managers who bought IG protection as a hedge or simply to bet that spreads will widen are bleeding premium without the reward. Just as was the case with VIX earlier in the year, CDX IG has become a poor generic hedge against spikes in risk. Part of the reason may be that banks such as JPM are hedging their own bonds (DVA). Note that CDX IG has a substantial financials component. That means even if dealers sell financials protection against their bonds (and not the whole index), it will still keep CDX IG relatively tight. And betting against JPM or other dealers may be a losing battle.

Tuesday, April 24, 2012

IFR/Reuters published an article yesterday on a group of banks bidding for the commercial real estate assets of Maiden Lane III (one of the two AIG rescue facilities). Not to be outdone, Bloomberg/Businessweek did their own story today. It's important to note (IFR didn't make it clear) that the bid is only for the CMBS portion of the portfolio (two CDOs).

Source: NY Fed

IFR/Reuters: - Citi, Goldman and Credit Suisse are joining forces to submit a combined bid for the bonds, which they believe will be more competitive than acting individually, sources familiar with the plan said on Monday.

The debt in the Maiden Lane III portfolio is known as the MAX CDOS, and the deals were originally arranged by Deutsche Bank.

Blackrock, who is managing this portfolio has been criticized for not extracting the full value for the Fed by entertaining this group bid.

IFR/Reuters: - “If Blackrock really wanted to recoup maximum proceeds for the taxpayer, they’d look into collapsing the CDO themselves, and auctioning off the individual bonds,” said Adam Murphy, president of Empirasign Strategies in New York, which tracks trading in securitized debt.

"Collapsing the CDO" however is easier said than done. In order to sell the underlying portfolio of CMBS securities held as collateral in the two CDO structures, one needs to control the CDO liabilities.

IFR/Reuters: Deutsche Bank already owns junior tranches of the collateralized debt obligation (CDO) on offer and if it also purchases the senior parts it may hold majority ownership in the structure.

Therefore whoever wants to sell off the individual bonds first needs to buy the junior tranches from Deutsche. But that wouldn't be the end of it. There is also a rate swap (which has seniority in such deals) that needs to be terminated with Barclays before collateral could be unlocked.

Businessweek: - The CDOs could be sold intact or broken into pieces. An interest-rate swap contract with Barclays would need to be paid out to access the underlying bonds, eating into profits, according to JPMorgan Chase & Co. (JPM) (JPM) Deutsche Bank, which owns the most junior slices of the CDOs, would need to be bought out to break up the CDO, according to people familiar with the deals.

Barclays (actually the old Lehman people) even suggested that instead of selling the collateral, they would actually "re-tranche" the CDO to make the senior tranches better quality (more subordination) - "putting the humpty dumpty together again". That may make these bonds more attractive to institutional buyers, but would take time.

The Fed's exposure to Maiden Lane III has been declining as the interest payments from the deal are used to pay down the original loan against the facility.

Source: NY Fed

Once that's paid off, AIG gets its loan paid and the remaining cash flows are all profit for the Fed (shared in part with AIG). However it is important for the Fed to move quickly. Here are the reasons.

1. Trying to sell the collateral may not necessarily get the best price because the Fed/Blackrock would be dribbling out 103 separate CMBS bonds. That in turn could push down the market for this type of paper and may even spill over into other markets as was the case with Maiden Lane II. And to unlock the collateral, deals would need to be struck with Barclays and Deutsche. These negotiations may take more time.

2. Under the Volcker rule and with Basle III, the dealers will be allowed to hold far less inventory, making it much more difficult for them to take down a big slug of structured credit paper. It would be easier to do this trade before these new regulations are in place.

3. If we have another major market disruption driven by events in Europe, nobody is going to touch this paper for a while.

4. There is a risk that the US economy takes a turn for the worse. That would put further pressure on the commercial property markets, potentially impairing more of the CMBS paper.

The sooner the Fed unloads this wonderful portfolio the better. Because next on the sell list, after the CMBS CDOs, are the Maiden Lane III ABS CDO bonds of much greater size.

As discussed before, the ECB no longer has control over liquidity conditions in Greece. The argument that one should be looking at the aggregate position of the Greek private sector with respect to the Eurozone as a whole is flawed. The Greek private sector can generally only rely on the Greek banking system for credit. At the same time the Greek private sector is moving liquidity out of the country, dramatically shrinking the availability of credit.

The chart below shows year over year growth in Greek deposits of non-financial customers - down 21.5% from previous February.

Source: GS

It's important to note is that the outflows are not just coming from Greek households. Corporate and foreign deposits have been declining as well. Banks have become incapacitated as the run on the banking system continues.

Source: GS (click to enlarge)

Reuters: Another priority was restoring the flow of credit to the economy as Greek banks curbed lending because of a large outflow of deposits, the [EU] paper said.

The nation has become isolated. Anecdotal evidence suggests that Greek refineries for example are unable to obtain credit and tend to rely on Iran for crude oil supplies. The situation does not seem sustainable and any expectations of near term economic growth are simply unrealistic.

JPMorgan recently performed a study on the composition of portfolios managed by life insurance companies. The study looked at the top 20 life insurance firms using their regulatory filings. These are the portfolios set up to support projected policy claims. The reason it is important to measure the composition and the changes in such portfolios is that life insurance firms manage $1.9 trillion in assets. Here is the current breakdown.

Source: JPMorgan

What stands out is that a third of the allocation is to corporate credit. That bucket includes both IG and HY, with a rating of A and higher making up nearly half of the allocation. BBB bonds make up 43% of the corporate credit allocation, leaving about 8% for HY.

The next chart shows dollar changes across the allocations over the past one year and also six years. It demonstrates how life insurance firms have provided the bid for investment grade corporate credit. There has been a substantial reduction however to bonds of financial firms. The other major declines have been in structured credit and equities (aging population forces these firms to reduce riskier assets as disused earlier). Structured credit has included a rebalancing toward ABS (pooled credit cards, auto loans, etc.), which are short maturity and have performed well.

USD billion

On a percentage basis we see a large increase in treasuries and agencies as well as munis. JPMorgan attributes this to the fact that there is a limited supply of high quality spread product: "there is a shortage of spread Fixed Income product which is contributing to the growth in Treasury holdings."

Source: JPMorgan

Going forward it will be increasingly difficult for life insurance firms to meet their portfolio growth requirements as spreads and yields are now near historical lows. That will translate into reduced earnings for these firms as more of the premium would need to be put away to meet policy claims.

Monday, April 23, 2012

The concept of German decoupling from the Eurozone recession may have been wishful thinking. The latest German Manufacturing Purchasing Managers' Index (PMI) has converged with that of the Eurozone as a whole. Manufacturing PMI is a closely watched index and tends to be a leading indicator for the GDP.

German (white) vs. Eurozone (orange) Manufacturing PMI (Bloomberg)

In response, Spain's 5yr sovereign CDS hit a new record high of 511bp (previous high was 510 on 4/16). The Eurozone is headed for a double dip.

Sunday, April 22, 2012

Here is interesting interview with Patrick Chovanec (professor at Tsinghua University's School of Economics and Management in Beijing, China). Dr. Chovanec points out that the official numbers for inflation, the GDP growth, and corporate earnings may all be misstated to look materially better than reality. When he brings up a number like 4% GDP growth, the Bloomberg reporter nearly has a stroke.

Chovanec writes about the reliability of China's inflation numbers in this EconoMonitor post:

Last summer, for instance, the Chinese government dumped a big chunk of its 220,000-ton strategic pork reserves onto the market. That helped ease prices, but it also lowered the profit incentive for farmers to raise and supply hogs, which could lead to shortages and/or higher prices in the long-run. The government fined Unilever for talking about raising soap and detergent prices due to soaring raw material costs. Although it later allowed those price hikes to go forward, the government leaned heavily on both Chinese and foreign companies to avoid raising their prices. Such practices continue. Just last week, the NDRC pressured two Chinese cooking oil producers into postponing a planned price increase for at least two months, and called Nestle in for “consultations” over a recent increase in the price of its baby formula products.

It's not that China is necessarily "cooking" inflation growth numbers, but these policies and pressure tactics artificially and temporarily suppress inflation, making the numbers appear better than they really are.

People often ask why it is taking this long to implement the new US derivatives regulation (part of the Dodd-Frank legislation). Well, it starts with zealous politicians who know all about the province of Kandahar in Afghanistan (because they are all about the "war on terror"), but know little about the global banking system or what a swap is for that matter. Then the implementation gets turned over to domestic regulators such as the SEC and the CFTC who themselves don't fully understand international banking. The CFTC had enough trouble regulating MF Global - and now they are asked to deal with Deutsche Bank's London subsidiary? The SEC has hundreds of hedge funds to register and audit while they can't even implement proper disclosure rules for public companies. It's no wonder that confusion has overtaken this derivatives regulation implementation.

Here are some basic questions that should have been addressed when the rules were designed, not during the implementation process.

Example 1: A US bank subsidiary doing derivatives business in the EU.

If a US domiciled bank owns another bank in the EU jurisdiction, does this other bank need to comply with the US rules? If yes, how would it compete with other banks in its jurisdiction that are not owned by a US bank? If no, the US bank would simply move some of it's derivatives business to the EU subsidiary to get a better regulatory treatment. Would the EU be able to synchronize its derivatives regulation with the US (to take out the loopholes) when EU members can hardly agree with each other? How long will it take?

Example 2: An EU domiciled bank owns a US subsidiary.

Clearly the US subsidiary will need to comply with the US rules. But should the parent bank as well? If yes, than the CFTC/SEC would have jurisdiction in the EU, really annoying EU bank regulators. If no, then how is JPMorgan to compete with Deutsche Bank within the EU when they are under different regulatory frameworks.

FT: US banks including JPMorgan Chase have warned that if their overseas subsidiaries are forced to adhere to US rules, they risk losing business to the likes of Deutsche Bank and Barclays. But foreign banks have warned that the language of US rules could subject them to worldwide supervision by US authorities.

Example 3: A US bank subsidiary doing derivatives business in the EU with an EU based client.

A derivatives client generally doesn't care where she executes a swap. A US based client for example could and often does execute swaps with a London-based bank (which may be a subsidiary of a US, a German, or a Swiss bank). A bank subsidiary is Brussels or Zurich could do just as well. Should there be a difference between US based clients and foreign based ones? What do you do with a hedge fund client domiciled in the Caymans? Nobody is even talking about Hong Kong or Singapore based subsidiaries with their own set of regulations and loopholes.

FT: ... the CFTC is examining whether a US bank’s foreign subsidiary transacting with foreign counterparties should be exempt from some new rules governing derivatives dealers if the subsidiary’s home country financial supervisors adopt robust oversight. A foreign bank’s derivatives desk also may be exempt from US rules if its national regulator employs rules closely mirroring those of the CFTC.

The CFTC is now under so much pressure in trying to resolve some of these issues, the agency has decided to postpone imposing some of the new rules on entities that are in foreign jurisdictions. Of course that includes the London swaps desks of JPMorgan for example - which basically means business as usual in London?

FT: The US Commodity Futures Trading Commission is looking to grant a temporary exemption to swap dealers that may fall under the jurisdiction of foreign financial authorities from complying with a host of post-financial crisis regulations governing derivatives transactions, people familiar with the matter said.

Confused enough yet? Well, seems so is the CFTC. Realizing the scope of the problem, the agency decided it is overwhelmed enough implementing the rules for the largest dealers. For now it simply can't deal with hundreds of smaller derivatives players.

Reuters: The CFTC originally said in December 2010 that firms would be counted as swap dealers if they traded more than $100 million in swaps over a 12-month period [numerous hedge funds trade 10 times that in a year].

That threshold set off a desperate push by energy companies and big commodity traders, who argued that they are using trades to hedge against market risks, and that their exposure does not endanger the broader financial system.

The final version released on Wednesday bumps the threshold up to $8 billion for most asset classes as an initial phase-in. Eventually, that threshold drops to $3 billion, unless regulators decide a different threshold is appropriate.

It was easy in 2009 to "regulate it all, ask questions later". Now the questions are being asked and the answers are not easy to come by. Some of this regulation will be so convoluted and confusing, it may create more risks than it originally intended to address. And as before, the dealers will find some loopholes because they can always afford better lawyers and structurers than the CFTC.

There is still some debate out there about how Eurozone's TARGET2 imbalances increased so much last month. The answer is simple. The national central banks (NCBs) in the periphery used TARGET2 to plug the holes in their balance sheets generated by the second 3-year LTRO. We saw that the Bank of Spain plugged a €55bn hole with TARGET2. Bank of Italy did the same but their portion was materially larger. Not only did Bank of Italy have to fund the LTRO (to the tune of about €127bn), but the central bank also had a reduction in deposits from the government and a drop in bank reserves (another €10bn). That's about a €137bn hit to the balance sheet and here is how this outflow was "funded".

How Bank of Italy "funded" LTRO-II (€127bn), and other outflows (€10bn)

TARGET2 balance sheet plug for March alone represented €76bn, bringing the total "Other liabilities within the Eurosystem (net)" to €270bn - a bit of an increase from the last time we looked at Bank of Italy (when this number was €194bn).

On a combined basis Bank of Italy and Bank of Spain have plugged a €131bn balance sheet gap in March. Note that when the NCBs "borrow" from the Eurosystem, they do not post collateral (they hold on to the collateral that banks post to them under LTRO). There is a reason that the Germans are concerned.

Ireland dealt fairly quickly with its property market bubble by effectively and forcefully nationalizing and recapitalizing its banking sector. They clearly still have a serious problem on their hands, but the nation has been aggressive in addressing the issue of distressed real estate loans. In contrast, Spain's banking system is nowhere close to fully recognizing the full extent of the problem. Not facing the problem however is not going to make it go away.

Reuters: "Banks are not recognising all of their risk. Many of their debtors are property companies with negative equity who can't even pay the interest on their debt," Fernando R. Rodriguez de Acuna, chairman of the consultancy, told Reuters by telephone.

He said the banks were covered for only 67.5 percent of that risk, leaving 40 billion euros of exposure if all the companies filed for bankruptcy.

The fate of the banks is being watched by international investors who fear Spain may be forced to apply for aid as the euro zone debt crisis enters its third year.

One of the issues the banks are dealing with is poor recovery levels on distressed property loans. Recoveries are considerably lower than anticipated.

FT: Repossessed properties in Spain are selling for about half their original value and are likely to continue to fall in value, according to a new report, underlining the parlous state of the real estate market in Europe’s fourth-largest economy.
Valuations on properties that were bundled up in securitisation deals and later repossessed are also significantly lower than data from the official housing price index suggest, according to a report from rating agency Fitch due to be published on Thursday.
...
Carlos Masip, Madrid-based director at Fitch, said: “If we view the market today we believe that there will continue to be a downward pressure on property prices. Home prices are still unaffordable for many when compared to income levels, there is a short supply of credit and a huge overhang of unsold properties.”

As discussed earlier, the amount of "recognized" bad debt has spiked. But this is thought to be only a part of the total delinquencies the banking system will be facing soon.

Just to give some perspective on the level of Spain's property crisis, consider the following chart showing housing prices over time in real terms compared to the Eurozone as a whole and to the US. Looking at the chart, consider the fact that the bulk of the loans on the books today were extended during the 2004 to 2009 period - right in the middle of the bubble. That's when the collateral was valued. This is why the recovery levels are so low and continue to decline.

Source: IMF

Spain will have no choice but to recapitalize the banking system as Ireland did a couple of years ago. But to do so the nation will need help from the Eurozone/IMF (as Ireland did). Unlike Ireland however, Spain's massive banking sector capital requirements will threaten to push the Eurozone the limit.

CNBC: ... economists believe that Spanish banks will have to turn to the euro zone's rescue fund, the European Financial Stability Facility (EFSF), for help in covering losses caused by a property market crash which has yet to end.

Likewise, investors are fretting about how Rajoy's center-right government can enforce deep austerity while reviving a recession-bound economy at the same time.

"They're going to need EFSF money to recapitalize the banking sector," said Carsten Brzeski, a senior economist at ING in Brussels. "I think we'll only see a real end to the Spanish misery if the real estate market stabilizes."

Investopedia is a great reference tool, particularly for those new to finance. But once in a while it provides advice that may not be entirely accurate. In an article entitled
"Commodities: The Portfolio Hedge" Investopedia tells you why commodities help "diversify" your portfolio.

Investopedia: Commodities tend to bear a low to negative correlation to traditional asset classes like stocks and bonds....

Source: Investopedia

Yes it is true that the average correlation between equities and commodities from 1970 to 2003 has been negative. But if we've learned anything from the financial crisis, it is that correlations are not static and tend to spike in a deleveraging environment (whether you are dealing with mortgages, equities, corporate bonds, etc.). The chart below shows the correlation between the CRB Commodity Index (or equivalent basket of commodities) and US equities going back to1915 - almost a century of historical data.

In a crisis a commodity basket may not be very effective in providing the diversification one would expect from historical correlations (reaching 80% in the recent crisis as commodities sold off with equities). The same thing happened in 1929. There is nothing wrong with having commodities in a portfolio of assets. One simply needs to be aware of the reasons the asset class is part of it. And the key motive to be long a broad basket of commodities is to protect against inflation, not to try "diversifying" the portfolio.

Update: Good comment from Kostas Kalevras:

There's basically a whole story about how Gorton et al 2004, induced institutional investors such as pension funds to invest in commodities futures as a hedge againt other asset classes. This investment was made through index funds and creates a perpetual long position on the underlying commodity futures. The liquidity injection was so large (of the order of $300bn by 2008) that it pushed oil and commodity futures to a contango situation playing a role in price increases as well as price volatility (due to the funds leaving partially after Lehman).

The process has been documented by various commentators, including the Fed:

Saturday, April 21, 2012

Asia continues to dominate foreign purchases of US treasuries. The latest estimate show China, Japan, and Hong Kong represented the bulk of treasury purchases from abroad in Q1 2012.

Source: JPMorgan

JPMorgan: The
estimates highlight that foreign investors purchased over
$150 bn of coupon Treasuries in the first quarter partly
funded by a decline in their holdings of Treasury bills.
This represents over 60% of net coupon issuance, a
significantly larger share than normal. January and February TIC Data released by Treasury this week, moreover, suggests that buying was especially strong in
Asia with mainland China, Hong Kong, and Japan together accounting for 80% of net foreign purchases compared to a long term average of 52%. The
apparent return of China to the Treasury market during
1Q12 should, for the time being, have generated a
welcome sigh of relief by Treasury officials as this large
investor sold nearly 10% of their Treasury holdings in 4Q12

FT: Argentina’s Senate is expected on Wednesday to approve a bill to nationalise YPF and expropriate a 51 per cent stake from Repsol of Spain by a comfortable majority, slashing the Spaniards’ holding to 6.4 per cent. The bill would then pass to the lower house of Congress, where it is expected to be passed into law speedily.

Is it really that easy? Spain and the EU may be slow to respond, but the response is coming. It is likely that the US will also support whatever action the EU takes. The response may come in the form of sanctions and/or freezing of Argentina's assets abroad (to the extent there are any), which Argentina can hardly afford. Certainly foreign investment will decline. Any chance of Argentina resuming the issuance of dollar denominated bonds - something the nation has been trying for years - is now nonexistent. The same holds true for Argentina's private issuers.

IFR: Moves to renationalise Argentine oil company YPF have essentially closed the door on the few issuers from the country that could previously have tapped the international bond markets and have raised the spectre of a lengthy debt restructuring at the company itself.

The 5-year Argentina CDS spread has spiked to around 1,000 bp.

In a free floating FX market, one would also also see a decline in the value of the currency associated with such loss of confidence. But of course Argentina is controlling the peso exchange rate. There is however a way to determine the true value of the peso - via the shadow FX rate, implied in the value of domestic bonds traded abroad. The peso value in the shadow markets is indeed sharply lower.

Source: JPMorgan

This is an indication of capital trying to flee the country via unofficial channels. Argentina's foreign reserves which have been used to prop up the economy are sure to start dwindling. The inflation rate of around 10% will spike further as the puppet central bank will be used to print more peso. There is an enduring and painful price to pay for stealing foreign assets in order to gain popular support.